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Milestone Matters - Winter 2004 Newsletter"A fat wallet is the enemy of superior investment returns." Warren BuffetEditor's Corner
Dear Friends, Investors and Associates: New York is locked in the cold grip of a fierce winter with temperatures in Central Park rivaling those of the Winter of '98... that's 1898. Fortunately, in lieu of recreating outdoors, we have entertainment offered by the National Football League and for those disinclined toward sports and bizarre half time extravaganzas, there is the dizzying spectacle of the Democratic caucuses. I know this political exercise has many critics, but I find it, via C-Span, an extraordinary pageant of retail democratic politics and come away from it filled with respect for the arduous efforts of the aspiring politicians and the earnestness of the volunteers. It is heady to think that the most powerful office holder in the world could emerge from these proceedings. I am happy to report that amidst these diversions, venture prospects are bright. I believe the current VC investment pace of $4 billion per quarter will accelerate in the second half of 2004. It is encouraging to note that there were 81 IPOs of venture-backed companies in 2003 and the average performance of these stocks has been an upward move of 51%. Also, merger and acquisition exits totaled 215 in Q3 of 2003. Lest I paint too optimistic a portrait, there are some troubling ideas brewing in the VC community. As is often the case, these initiatives have been undertaken by smart people armed with good intentions. (Think Vietnam). The first of these is the product of PEIGG (Private Equity Industry Guidance Group). Populated by veterans of the venture business, the committee is trying to establish a sensible uniform valuation methodology for the private equity asset class. To date, the widely adopted and very conservative procedure for valuing venture portfolio holdings is to downgrade them in the face of poor performance and only to upgrade them when triggered by an equity financing from an unrelated third party. PEIGG's understandable criticism of this approach is that it frequently undervalues portfolio companies that are performing superbly but have not yet experienced another financing event, which would trigger an uptick in value. PEIGG's proposed "solution" is to encourage General Partners to exercise their judgment and to raise portfolio valuations when company performance warrants. The second development which has a pernicious unintended link to the PEIGG initiative, is the new so called "tough terms" which are being advocated by venture fund investors. These investors are smarting from their experience with low venture returns in funds they backed primarily in the 1998 - 2000 period. These measures include "opt-out" provisions, which would permit limited partners who become disenchanted with a fund not to honor future capital calls without any attendant penalties to their LP interests. The structure of venture partnerships which assures that a certain capital base is available for a full investment cycle - normally 10 years - would be undermined by this "reform" and would have a devastating negative impact on the business. To operate effectively, a venture fund must know with precision what capital is available to it so that it can invest and support its worthy companies, particularly during hard times. The envisioned reform assumes that at a point in the evolution of a fund, perhaps three or five years after inception, it is possible to discern how matters are evolving and whether it is better to exit or to stay the course. With some notable exceptions, this kind of interim judgment is not feasible because young companies and venture portfolios do not progress along a linear up curve. Now, if the industry combines LP "opting-out" with GP flexibility as to the writing up of asset values, it is courting trouble. So we are hoping that the disappointments of the last few years, will not lead to "reforms" which will worsen the situation and hamper an investment discipline that, on the whole, has performed extraordinarily well. But for these threats to the established venture capital order, we are pleased as we survey the landscape closer to home. The New York region continues to spawn many interesting opportunities led by entrepreneurs who respect capital and understand that evolving technologies create new markets. We remain very busy assessing investments and nurturing our portfolio and are very optimistic about MVP II's prospects for 2004. As always, we welcome your comments and questions. With best wishes for a happy, peaceful and prosperous year,
General Partner
MVP II Portfolio News Derivatives Portfolio Management (DPM), a provider of fund administration, back and middle office outsourcing and risk transparency solutions for hedge fund managers and large institutional investors, raised $6.5 million from Putnam Lovell NBF Securities Inc. ("Putnam Lovell NBF"). The valuation was at a substantial increase from the valuation at which Milestone invested in 2002. Putnam Lovell NBF, a unit of National Bank Financial Inc. (one of the top six brokerage firms in Canada), is a merchant bank focused on the financial services industry, and is recognized as one of the preeminent M&A advisors to asset managers. DPM intends to leverage Putnam Lovell NBF's institutional relationships to expand assets under administration from its current level of $18 billion. In turn, Putnam Lovell NBF intends to utilize DPM's advanced administration capabilities to accelerate and to expand its hedge fund-related products and service offerings to institutional investors. DPM expanded assets under administration by 80% in 2003. In addition, DPM was ranked by Global Custodian, a leading industry publication, as the top-rated fund administrator in the $10 billion to $20 billion assets-under-administration category in the 2003 Hedge Fund Administration Survey.
Think Small Milestone is in the small deal business. We focus on small transactions in part because our investment size is small (approximately $1 million over the life of the investment). In addition, we believe the market for small transactions (less than $5 million) is the least competitive and thus the most attractively priced segment of the venture capital market. But all small deals are not created equal. In fact, we insist on one very important characteristic when we evaluate an investment opportunity: capital efficiency. There is no absolute definition of capital efficiency. What is profligate overspending to Milestone may be the ultimate example of penury to another venture capitalist. In the context of our strategy, it means we invest in companies that have the option to build growing, profitable enterprises and generate significant shareholder value with one or two modest rounds of investment (e.g. $7 million over two rounds). Of course, it does not always work out this way, as companies often stumble and therefore consume much more money than anticipated. In the opposite case, where a company is thriving, the smartest thing to do may be to raise a much larger second round of capital ($8 million+) and swing for a home run; for example, when a company is fortunate enough to be in a large, growth market with tremendous demand for its products and services but where only a short window of time exists to capitalize on the opportunity. The problem is that very few entrepreneurs, and venture capitalists for that matter, want to admit that their company is not one of those fortunate few firms that merit a large capital infusion. Like the children of Lake Wobegon, every child is "above average." Therefore, too often, the preferred course of action is to pursue a "get-big-fast" strategy, even when valuation has hopelessly outpaced the underlying fundamentals of the company. The hope is that somewhere down the road, the gods will be kind and it will all work out as hoped. There are several reasons why this line of thinking generates poor shareholder return. First, financial common sense tends to evaporate when a large pile of money is in the bank. The virtue of having very little money as a young company is that it focuses the mind, inspires resourcefulness, and promotes wise decision making. On the other hand, when lots of cash is available, management can easily lose focus by pursuing new markets, new products and acquisitions before there is a rational business case. Also, a management team that can successfully execute a business plan with 30 employees often gets overwhelmed by a premature expansion to 120 employees. There is, as well, an equally vexing structural problem with over-funded companies, which presents a stark new reality venture capitalists must contemplate going forward: the venture capital market is in the process of reverting to its historical mean in terms of exit values. When median IPO valuations for venture backed company's crested above $300 million in 1999, it didn't matter if a company raised an extra $15 million or $25 million of capital; 5x to 10x returns were still very achievable and the payoff came so soon that all interested parties were euphoric. However, if IPO valuations return to their historical norm (they have every indication of doing so) of between $70 million and $110 million (total value), as they were from 1994 through 1997, then companies that raise more than $15 million of venture money are going to have a very hard time of generating 5x to 10x returns for their investors. The problem is compounded by the fact that it is going to be harder and take much longer to get public in the first place. The historical merger and acquisition market paints an even worse picture. From 1994 to 1998, average venture-backed valuations for M&A transactions ranged between $45 million and $70 million. The outlier years were 1999 and 2000, at $156 million and $221 million respectively. Given that most venture investors get liquid from M&A events, not IPOs, every extra $5 million of unnecessary capital that goes into a company can make or break an attractive return. After considering such thorny logic, we find it strange that over 70% of new money going into venture funds in 2001 went to large funds (over $250 million). Large VC funds are in a tough position. They need to put $10 million or more into each deal. If they syndicate, which promotes good risk management, each of their portfolio companies will have a minimum of $15 to $20 million of venture money (of course usually much more goes in). We just don't feel there will be sufficient liquidity to provide attractive exits for all of these over-funded deals. Thus we are sticking to an investment
strategy where we invest in capital efficient companies that have
the option to generate 5x to 10x returns on exits between $50
million and $150 million. We
hope a few, maybe even several, can do much better, with or without
a large capital infusion, but we don't want to depend on it.
Milestone Venture Partners Investing in early Stage Enterprise Information Technology Companies in the New York Metropolitan Area
551 Madison Avenue, 7th Floor, New York, NY 10022 V: [212] 223 7400 F: [212] 223 0315
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About | Approach | Management Team | Advisory Board | Portfolio | Firm News | Contact551 Madison Avenue, 7th Floor, New York, NY 10022 V: [212] 223 7400 F: [212] 223 0315 |
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